Is Federal Stimulus Good for Housing?

Recently, the Federal Reserve hinted at winding down its $85-billion-a-month bond-buying program. The reasoning is to avoid trampling the green shoots of the country’s fragile housing market.

However, is the economy ready for an end to the stimulus?

So, what is the thinking behind the Federal Reserve's plan to wind down its economic stimulus program, and how is the issue likely to be tackled by chairman Ben Bernanke's successor?

Officials at the Federal Reserve said last week that they plan to reduce the amount of bonds they buy, basing their purchases on their confidence about jobs and inflation. Although no date has been given, officials are reportedly working on clarifying the strategy so financial markets don’t have an overreaction to any moves. The Fed’s stimulus pushed mortgage rates to record lows, experts say, which has helped fuel the housing market recovery. “The housing market is no different from the bond market and equity market,” says Mark Grant, managing director at Southwest Securities in Dallas. “It’s artificially inflated.”

Unfortunately, no matter how the Federal Reserve reduces its bond-buying program, it is certainly bound to have an impact on housing, analysts say. “If it just pulls out, it will be a catastrophe,” Grant says. Current policy favors borrowers, he says, while penalizing those who save and invest.

A gradual withdrawal of Federal Reserve funds will also throw a spanner in the current refinancing boom, others say. Historically low mortgage rates — 3.5% for a 30-year fixed rate versus 6.1% in 2008 before the Fed began buying back mortgage-backed securities — have led to a strong increase in refinancing in recent years with some homeowners refinancing more than once to lock in lower monthly mortgage repayments. “If the Fed cuts back on actions that have kept mortgage rates low, the main effect of higher rates would be a drop in refinancing activity,” says Jed Kolko, chief economist at real estate listing site Trulia.

To be sure, some say an early housing recovery will weather a phasing out of QE3, the Fed’s economic stimulus also known as quantitative easing. The housing affordability index is still near record highs of 200, according to the National Association of Realtors. That is, the average household has 200% of the qualifying income needed to purchase the median-priced home, financed with a 30-year fixed-rate mortgage. “Even if mortgages rates rose gradually back up to 5% to 6% over the next five years, they would still be lower than any time between 1970 and 2000,” says Mark J. Perry, a professor of finance and business economics at the University of Michigan-Flint. “When the Fed does start allowing rates to rise, it would be so gradual that people would adjust to the new environment.”

Larger homes will be the most likely to feel the impact of higher rates as more would-be home buyers feel less confident about moving up the property ladder. “Higher rates would mean that homebuyers would not be able to afford as expensive homes,” Kolko says. That’s bad news for those who are waiting to sell, he says, “as it would probably cause home prices to rise more slowly than they have been.” On the upside, Kolko says it will help prevent another bubble. Prices of existing homes soared 10.5% in March year-over-year, according to the latest figures from CoreLogic, a mortgage-data firm, representing the biggest year-over-year increase since March 2006.

In short, there is a consequence to all federal government actions that interrupt the normal course of market activity. The current injection of liquidity, while having a short term positive effect, may result in some serious long-term issues.